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Why I Bought Netflix

A Fool offers hope amid the panic selling.

Big news out of Netflix(Nasdaq: NFLX) last night. The leading supplier of streamed video programming has struck a deal with DreamWorks Animation(NYSE: DWA) in which the latter will forego pay TV as a distribution source for its films and TV specials.

This isn’t why I bought shares of Netflix 11 days ago, but it is reflective of why I still consider Netflix to be a tremendously disruptive competitor.

Neither Amazon.com(Nasdaq: AMZN) nor Hulu could have done this deal and given DreamWorks distribution that’s comparable to pay TV. Only Netflix has that sort of reach; Amazon and Hulu aren’t available on that many devices.

Netflix’s real source of competitive advantageBears will tell you that content is what matters and that deep-pocketed competitors will get more of it, destroying Netflix’s advantage. The company’s eroding position was an ongoing theme of the Fool’s Superior Investing Ideas conference in Alexandria last week.

You know what? I think the bears have it wrong.

Reach is Netflix’s advantage. Start a movie on a computer, move it to a tablet, and move it again to a TV, all without ever losing your place. Netflix does this seamlessly. YouTube, which has similar distribution but little premium content, has yet to figure this out. Hulu has the experience down but isn’t widely available. Amazon is great on a computer; not so great elsewhere.

Distribution -- or better yet, consistent distribution -- across devices is why Netflix accounts for roughly a third of primetime streaming bandwidth. The company’s content library is a small part of the equation.

Just look at the expiring Liberty Starz(Nasdaq: LSTZA) deal, which CEO Reed Hastings says accounts for only 8% of streaming traffic. Seems right to me; my kids are the primary Netflix users in our house and they’re most often found watching TV reruns. I can’t remember them using “Starz Play.”

It’s hard to be easyExactly 10 devices in our home offer Netflix. Hulu is present on four. Amazon is available on five. Our kids never choose Hulu or Amazon. Netflix is what they know and like most because it’s easy. There’s no downloading. There’s no configuring. Sit, click, and watch.

Most interesting are the days when my smallest two are watching a rerun on the Wii while my oldest watches his shows on his MacBook Air as my wife and I catch up on old USA Network shows upstairs. Netflix handles all the streams from our one account. Granted, this doesn’t happen often, but consider the infrastructure required to deliver these streams simultaneously and seamlessly.

Not only do you need a distributed server network attached to a massive storage array. You also need high-speed point-to-point connectivity to pull from storage systems and deliver to my home network. Level 3 Communications(Nasdaq: LVLT) seems to be doing most of the heavy lifting in this area.

You also need algorithms capable of loading and logging each stream so that if I end a stream on one device and pick it up elsewhere, my place won’t be lost. And finally you need monitoring to track stream quality, and to reset automatically, if any point on the network becomes clogged.

My point? Tech simplicity often requires a tremendous amount of complexity. Netflix is no exception. Hulu and Amazon are going to have to bolster their distribution infrastructures and support a lot more devices in the quest to disrupt Netflix. Don’t expect it to be easy for either -- Amazon especially, having seen its cloud computing network, which supports Twitter and others, teeter and fail multiple times in the past year. (Affecting Netflix in at least one case, ironically.)

Not exactly losing the content warYet Amazon may very well be the one to crash Netflix’s profit party. Earlier today the e-tailer announced a breakthrough streaming deal of its own, with News Corp.’s (Nasdaq: NWS) Twentieth Century Fox.

Before that prompts you to sell, look at what’s being offered. Amazon is getting old videos to stream to Prime members. Think of it as a lightweight version of what Netflix gave up when it chose not to pay $300 million to renew the Starz deal.

DreamWorks, on the other hand, will give Netflix streaming rights to new films that would otherwise be distributed via pay TV channels such as HBO. The deal, which kicks off in 2013, isn’t cheap; Netflix could pay upwards of $30 million per film, according to reporting by The New York Times. But it does represent a shift. Studios want content to go where it’ll be seen most and the Internet is the world’s most pervasive network.

The illusion of staticAssuming Netflix would fail to find a workable streaming model always struck me as a loser’s bet. Sure, studios want more for content, but let’s not forget we’re only a few years removed from Steve Jobs convincing a once-immovable music industry to accept $0.99 a track pricing in exchange for seamless distribution via the iTunes Store and iTunes software, which was built not just for Macs but also all iOS devices and Windows. Creative distribution won out, and can win here too.

Let’s also remember that Netflix has a history of streaming titles for a time and then dropping them. So does Hulu. In streaming video, there’s no such thing as a static library. Netflix will make deals, end them, and then make new deals. Its library will change as it always has, leaving the abysmally named Qwikster DVD-by-mail unit as a secondary source for those who want content not available for streaming.

Feeding the bearsNone of this is to diminish the good bear cases made by my Foolish colleagues. Motley Fool Hidden Gems advisor Seth Jayson has a piece worth reading, as does my Motley Fool Rule Breakers teammate Rick Munarriz. I’m nevertheless content to remain in the bullish minority.

My take, simply, is that a legitimate but largely overblown content scare has tricked investors into forgetting about Netflix’s true advantages -- distribution and simple pricing. Advantages that continue to disrupt a cable and satellite industry that produces more than $100 billion in annual revenue. Netflix has less than $3 billion by comparison, but if I’m right, its share will grow geometrically from here.

Do you agree? Disagree? Please weigh in using the comments box below. And if you’re in the mood for more Web-centric stock ideas, try this free video. You’ll walk away with a better understanding of the cloud computing movement that Netflix is profiting from and a winning stock idea from our Rule Breakers scorecard. Click here to watch now -- it’s 100% free.

Author

Tim Beyers first began writing for the Fool in 2003. Today, he's an analyst for Motley Fool Rule Breakers and Motley Fool Supernova. At Fool.com, he covers disruptive ideas in technology and entertainment. Find him online at timbeyers.me or send email to tbeyers@foolcontractors.com. For more insights, follow Tim on Twitter.